When it comes to our financial futures, the one thing we’re most scared of is uncertainty. It would be great if we could look into a crystal ball to see what the future will hold. When you devise your investment plan a lot of assumptions have to be made because we just don’t know what will happen.
Many assumptions are based on average best guesses – what the markets will do in ten years, where interest rates will be in twenty, how much your expenses will be in the future, and what your health and life expectancy will be.
But what if your life turns out to be not so average? What if you hit retirement and there’s a downturn in the markets, or the inflation rate starts to soar, or you have an unusually long life span?
Your plan might look reasonable and achievable, but you can’t cling to a false sense of security that you’ll know where you will be in twenty or thirty years. What will happen if your plan doesn’t work out?
You need a stress-test.
Worry #1 – Outliving your money
Some retirees unnecessarily adopt too frugal of a lifestyle out of fear of facing financial ruin. Reliable retirement income is your primary goal. Plan for a safe and sustainable withdrawal rate from your savings. The 4% rule of thumb is a good starting point if you retire at age 65.
You could also consider allocating a portion of your retirement portfolio to a pension-like income stream with one or two annuities, thereby insuring income for life.
Worry #2 – Poor investment decisions
Let’s face it. Most of us have made terrible investment decisions at some time – the over-hyped stock; mediocre high fee mutual funds; bailing out when we should have stayed the course. You may feel the pressure to make up for mistakes. That pressure can often lead to investing in a dubious “high-return” product hoping it will solve your problem.
What would be the impact if your most risky investment took a dive? How confident are you that you’ll at least get close to market returns?
The best plan is to invest in well-diversified investments based on your individual profile and circumstances, either on your own or with the help of an investment advisor. If you already have a good strategy in place, there is no need to make major changes when you retire. Predictability is more important than sky-high returns.
So, the next time you’re tempted to attend a seminar touting “low-risk, high return” investments such as real estate development shares, foreign currency futures and precious metal mines, go ahead and take advantage of the free lunch and the prize for attending, but leave your chequebook at home.
Worry #3 – Inflation starts rising fast
A low inflation rate may not be noticeable in the short term, but it can have a big impact on the purchasing power of your savings over a lengthy retirement.
Include investments that are resistant to surging inflation, such as real-return bonds (which are indexed to inflation) and dividend paying stocks.
Retirees are especially vulnerable to rising interest rates because they tend to rely heavily on fixed-income investments. Assess the impact of potential interest rate increases on your fixed-income investments by looking at their duration, which measures a bond fund’s sensitivity to changes in interest rates. The longer the duration, the more the price will fluctuate when interest rates change.
For example, if your bond fund has a duration of 6 years, that means its value will drop by roughly 6% for every 1% increase in interest rates. Broad-based bond funds and ETFs typically have a duration of around 6 or 7, while short-term funds have a duration of around 2.5 to 3. You can get duration estimates for Canadian fixed-income mutual funds and ETFs from their individual websites.
Worry #4 – You incur unexpectedly high costs in later years
Unexpected expenses could relate to any number of matters, including health and long-term care needs, rising prescription costs, a need to help other family members, changes in public policy, fraud and theft, and changing housing needs.
It can cost $1,500 to $3,000 a month for a single senior to rent a studio apartment in a retirement home, and up to $6,000 if sharing with a spouse. Costs vary greatly across Canada and also depend on the type of accommodation.
Private extended care facilities can be even pricier. Government run facilities cost less but may have long waiting lists. You also have the option of remaining in your home and paying for home care.
How will you get the money to pay for that? It’s important to research the costs in the area you wish to live in so you’ll be financially prepared.
You may want to consider long-term care insurance. Another option is to use the proceeds from selling your home, or refinancing to pay for in-home care.
Plans change and the unexpected occurs.
Retirees must have the flexibility and liquidity to manage unplanned expenses. You may be fortunate and not incur any of the above risks, but it’s still prudent to have a Plan B. It’s important to allow for contingencies and give yourself some wiggle-room.
If you can get a handle on the risks and make any necessary changes to get yourself back on the right track, you’ll have gone a long way toward increasing your chances of having a secure and comfortable retirement.